Bank of America Is Actively Preparing For The Chinese January 31 Trust Default

Last week we were the first to raise the very real and imminent threat of a default for a Chinese wealth management product (WMP) default - specifically China Credit Trust's Credit Equals Gold #1 (CEQ1) - and its potential contagion concerns. It seems BofAML is now beginning to get concerned, noting that over 60% of market participants expects repo rates to rise if a trust product defaults and based on the analysis below, they think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and back-coupon on the day. Crucially, with the stratospheric leverage ratios now engaged in such products, BofAML warns trust companies must answer some serious questions: will they stand back behind every trust investment or will they have to default on some or potentially many of them? BofAML believes the question needs an answer because investors and Trusts can’t have their cake and eat it too. The potential first default, even if it’s not CEQ1 on 1/31, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event.

...borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).

Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.

Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.

So the PBOC's efforts are merely exacerbating the situation for the worst companies... and as BofAML notes below, this is a major problem...

The 3bn CNY Beast Knockingvia BofAML's Bin Gao

CNY stands for the currency, and also a beast

CNY represents China’s official currency. It also stands for Chinese New Year, the biggest holiday for the country and the occasion for family reunions and celebration. But less familiar for many, however, the Year (?) itself actually stood for a beast which comes out every 365 days and eats everything along the way from bugs to humans. The holiday tradition started as a way for people to fend off the beast by getting together and lighting up the firecrackers.

At the same time, custom dictated that people also to paid their due to avoid becoming the beast’s target. In particular, it has been a tradition to settle all debt before the New Year. From the perspective of such folk culture, the trust product Credit Equals Gold #1, referred as CEQ1 hereafter, by China Credit Trust planned poorly for having the maturing date on the New Year, leaving a 3bn CNY beast running wild.

High probability for the trust product to default

Though the term default is used quite frequently, there are actually confusions on what constitutes a default in this case when talking to investors and especially onshore investment professionals. To simplify the issue, we define a default as failing to pay the promised contractual amount on time.

The product, CEQ1, is straightforward. It is CNY3.03bn financing with senior tranches of CNY3bn and junior tranche of CNY30mn. In principle, the senior tranches are also equity investment, but the junior tranche holder pledged assets for repurchasing senior investment at a premium. The promised rate was indexed to PBoC’s deposit rate with a floor for three classes of senior tranches at 9.5%, 10% and 11%, paid annually (detailed structure is illustrated below).

In a sense, the product is in technical default already. The last coupon payment in December, with nearly all the money (CNY80mn) left in the trust account, came in at only 2.7%, falling far short of the promised yield. The bigger trouble is the CNY3bn principal payment, along with the delinquent coupon, on 31 January.

We see high probability of default on 31 January

Political or economic consideration: ultimately, given the government’s strong grip on financial institutions, default may be a political decision as much as an economic decision. From that perspective, CEQ1 would be a good candidate for default. The minimum investment in CEQ1 is CNY3mn, much more than the typical amount required for other trust investment and 75 times of per capita GDP in China. If defaults were to be used to send a warning signal to shadow banking investors, this group of rich investors may have been a good target because the government does not need to worry too much of them demonstrating in front of government offices.

Timing: there is never a good timing for deleverage because of risks involved. But the current job market situation provides a solid buffer should defaults and subsequent credit contraction slow down the economy growth. The government planned 9mn jobs last year; instead it has created more than 12mn by November. So the system could withstand a potential shock.

Financial capability: China Credit Trust has a bit over CNY10bn net assets, which some analysts cite as evidence of the trust company’s capability to fully redeem the product first and recover from the collateral asset later. However, the assets might not be liquid enough, so the net asset is not the best measure. Based on its 2012 annual report, the company has liquid asset of CNY3bn and short-term liability of CNY1.35bn, leaving liquid accessible fund of CNY1.65bn at most. ICBC for certain has much deeper pocket, but it has declared that it won’t be taking major responsibility.

Career concern: To certain extent, the timing was unfavorable for another reason, the ongoing anti-corruption campaign. It is reported that there are around 700 investors involved. On CNY3bn senior tranche investment, it averages CNY4.3mn per investor. We do not know the exact identity but with CNY3mn entry point, we know no one is a small-scale investor. Legally unjustified, if either China Credit Trust or ICBC decided to pay 100% with their capital, the decision maker would have to ensure that he does not have any business deals with any of the 700. Because if he does, his career or even his freedom could be in jeopardy in the current environment of ongoing anti-corruption campaign and strict scrutiny of shady deals/personal favors.

Questionable asset quality and uncertain contingent claim: There are cases in the past of near default, but most of them involved collateral of real estate assets, which have at least appreciated over the years. The appreciation of collateral assets makes it easier for the third party to step in by paying back investors and taking over the collateral assets. This particular product involves coal-mining assets whose value has been decreasing over the last couple of years. Moreover, there have been multiple claimants on these assets, as exemplified by the sale of Yangjiagu coal mine. Although the mine was 51% pledged through two levels of ownership structure, only 20% of the sales proceed accrued to trust investors (Exhibit 1 above). Such a low percentage would be a deterrence and concern to whoever contemplating a takeover of the collateral assets.

Other cases less relevant: In the past, one way to deal with the issue was for banks to lend to shareholders of the existing collateral asset owners for them to payback investors, with explicit or implicit local government guarantees. Shangdong Hailong’s potential default on bond was avoided this way last year. However, in the current case, the owner has been arrested for illegal fund raising, making the past precedence less applicable.

Putting all the above reasons together, we think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and backcoupon on the day.

Immediate impact would be for China rates curve to flatten

The case has been widely covered in the media. However, many still believe one way or the other the involved parties will find a last minute solution to fully redeem the maturing debt. So if the trust is not paid, we believe it will be a big shock to the market.

China rates market reaction, however, might not be straightforward. On the one hand, default would likely lead to risk-averse behavior, arguing for lower rates. On the other hand, market players would likely hoard cash in such an event, leading to tighter liquidity condition and pushing money rates higher.

We think that both movements are likely to ensue initially, meaning higher repo/SHIBOR rates and lower CGB yield if default were to realize. We suggest positioning likewise by paying 1y IRS and long 5y CGB. On the swap curve itself, we think the immediate reflection will be a bear flattening move.

Interestingly, an informal survey conducted on WeChat among finance professionals suggests the same kind of repo rate reaction (Chart 1). We think this survey is important because we believe these investment professionals will likely behave accordingly because the default event is not priced in and hard to hedge a priori.

Trust company can’t have their cake and eat it too

Of course, we can’t rule out that the involved parties do find a solution to avoid default. However, with a case as clear cut to us as this one favoring default, we believe such outcome would send a strong signal to investors that the best investment is to buy the worst credit.

Thus, we believe the near term market reaction with no default would be for the AA credit to shine brightly since this segment has been under pressure for quite some time. Trust investment would be met with enthusiasm and trust assets would likely expand further.

However, we see a fundamental problem in the industry; the leverage ratio has gone to a level which requires investors and trust companies to answer some serious questions: will trust company stand back behind every trust investment or will trust company have to default on some or potentially many of them? We believe the question needs an answer because the trust companies can’t have their cake and eat it too.

For the industry, the AUM/equity ratio has nearly doubled from 23 to 43 in less than three years during the period of 4Q2010 to 3Q2013 (Chart 2). Some in the industry has argued that one should only count the collective trusts since other trusts are originated by non-trust players like banks. Thus, trust companies have no responsibility for paying investors other than collective trusts.

We see two problems.

Even if we accept the trust companies’ argument, it is still questionable whether trust companies would be able to pay even a reasonable amount of default. The growth of leverage on collective trusts was much more aggressive. Collective trust AUM/equity ratio was 2.7 in 1Q2010 and 4.7 in 4Q2010 (Chart 2). It rose to 10 by 3Q2013, more than doubled in less than three years and more than tripled in less than four years. Along the way, the average provision has dropped from 84bp to 34bp when measured against collective AUM.

As the case of CEQ1 illustrates, as long as full redemption is on the table, no involved party could walk away totally clean. CEQ1 is a case of collective trust, but the ICBC still faces the pressure to pay. If the bank is being pressured to pay in the case of collective trust default, trust companies will likely be pressured to pay as well should some non-collective trusts get into trouble. If trust companies are on the line for the total AUM, their financial condition is even shakier, with average provision covering barely 7bp of total AUM as of 3Q2013.

On longer term market trend

Based on the analysis in the above section, we see a possibility for trust companies to have to let some trust products default with such high leverage and so few provisions. This is especially likely the case given that there will be more and more trust redemption this year and next year as a result of the fast expansion of this industry over the last couple of years and short duration of such products.

The heaviest redemption in collective trusts this year will arrive in the 2Q (Chart 3). Given that the financial system is stretched thin and there were more cases of near defaults on smaller amount of redemption last year (three cases in December alone), we believe some form of default is almost inevitable in the near term.

The potential first default, even if it’s not CEQ1 on 31 JANUARY, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event. Over the last year, China appeared to be mirroring what happened in the US during 2007, the spike of money rate (much higher repo/SHIBOR), the steepening of money curve (14d money much more expensive than overnight and 7d), and small accidents here and there (junior tranches of a few wealth management products offered by Haitong Securities losing more than 60%, a few small trusts and now CEQ1’s redemption difficulty).

Theoretically, China’s risk is best expressed using a China related instrument, but we also think the more liquid expression of China goes through the south pacific. The following points list our longer views on China and Australia rates.

We have liked using Australia rates lower as a way to express our China concern and we continue recommending doing so as a theme.

We recommend long CGB and underweight credit product. The risk for such positioning in the near term is no CEQ1 default. But we believe any pain suffered due to overt market manipulation to avoid default will be short lived since it has become much harder to keep the debt-heavy system in balance and the credit spread is bound to widen.

After a brief flattening on CEQ1 default, we see swap curve steepening as being more likely on more default threatening growth leading to easy monetary policy and more issuance going to the bond market.

We look for higher CCS rates due to the fact that the currency forward will more likely start expressing the risk.

"There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years."

What is this with all the central planning (or ex-central planning) economies naming everything with numbers in their names.Like the Bo'B Feed Matter Processing and Radionuclide Recycling and Food Processing Plant #7 or the People's Republic of America Perpetual Summer Fun and Reeducation Weight Loss Camp #44?

meh. more 'potential' causes for the cascade, but as has been the case since 2009, when a black swan presents itself, central banks will step in and shoot it out of the sky. I'm betting on the Legion of Boom vs. the Mile High Donkeys.

A opaque investment trust that was betting on mid-west railroad lands & growth in asset prices. The growth driven by surging crop yields and railroad car loads massively dissapointed vs. the 1927 numbers (markets were pricing in 19x forward earnings back then too), and the whole thing blew up.

JP Morgan was not a happy camper that day. Of course, this would definitly shut down the taper chatter and also explains why no Chinese senior officials are at Davos partying this year (esp. the Finance minister).

On another note: Funny how the SEC wants to go after Petrochina for buying Iran crude. Since when did SEC become a sanctioning agency, isn't that the Treasury's job ?

Every agency's job is now to PROTECT the 'currency reserve' status of the USD, that is why FBI/IRS have more field agents abroad than at home in NAZI-USA.

YES, the SEC's job is no to rule the world, not USA corporations or bankers,

Every FED agency's job is to make sure that the black-markets trade only in US DOLLARS, otherwise the entire USA-PONZI collapses.

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Is this news? Not

FBI isn't in the law enforcement job any more, ... all federal agencys are in the 'reserve enforcement' biz, ... from DHS, to TSA, to DEA, to IRS, to BATF, to SEC, to EPA, to USDA, and the USPS; of course the NSA decides where to send team USA-FED to 'enforce' teh racket.

The system, or I should say Eye of Sauron, now has taken all focus off of the biz of the USA, why not? There is no business left in the USA, only the JOB of FEMA to control the restless lemmings.

Leverage is like cocaine on the way up, and lethal dose radiation on the way down.

Anyone who believes that central banks can keep a sudden implosion ( the type that history is so frequently littered with in bubble-bustNomics) from happening for much longer is hopelessly naive, and given the incredible leverage that both legislative bodies (e.g. Congress and mark-to-fantasy accounting standards) and central banks (e.g. "Cash for Rehypothecated Trash") have encouraged to be built up at present, the next implosion will be of the more spectacular sort.

Bet they called in all quant to start doing their predictive modeling to prepare:) Maybe they learned from subprime and now they are going to model it all over the place to prepare? Banks have morphed into huge software businesses that control a lot of money, data and access..CIO did an interview a short while back, IT is our business..Algorithms have to run and shift money and assets quick, right?

Remember to lock in the 6mth war/skirmish with Japan. I see a Chinese general losing is nut and sending an attack on Japanese planes and ships. The Fed losing control, Obama losing his brain, mass protests globally. Thailand protests spreading, Indonesian conflict with Australia etc etc etc

The money power moves from West to East, and China will experience the same woes as other nations who assumed control from other failing empires after the vampire international financiers gutted one land, and moved on to another, for the next feudalism. China has created more QE, debt, slave wages and corrupt property law than any other nation on earth. Forget whinging about Abenomics, Chairsatan Bernanke so-called by his critics or the EUSSR (as I think of them). China is the ticking time bomb in the world financial and social system. The rootless cosmopolitan banksters like it that way. Tails, you lose. Heads, they win. Currency debasement in unison: USD, Euro, Yen and Yuan. Owners of real assets bought now win, as those currencies are being managed to implode in unison. A Goldilocks scenario; not too much, not too little. All marching in goose step ... until the nazi Trilateral Commission madmen have transferred all their control mechanisms to the East, safe from retribution in the West.

Shanghai, Hong Kong etc are their chosen escape routes, and the people of West and East be damned, under the jackboot of the rootless cosmopolitans.

If you think the system was bad just wait until the NWO overlords are in place we will all be subject to the same kind of brutality and control that the Chinese people have been. Our Global Neighborhood won't be like Mr. Rogers.

Gasp, an uninsured investment paying 9.5%, 10% and 11%... color me shocked, just shocked that this failed. 700 investors who each had an extra 5m CNY laying around? That's why the riskier shit like this has very high entry points, specifically because if anyone's gonna get fucked, it's gonna be rich people who got too damned greedy and were dumb enough to dump that kind of cash for multiple years. Of course, our idiot friend gordon chang thinks otherwise, mainly because he's a fucking know-nothing hack.

"Credit Equals Gold"? We've long known the Chinese will eat any four-legged thing but a table...now they've moved on to eating the Muppets. But for buying such an instrument, they have it coming. Maybe with a nice sweet and sour sauce.